Understanding Methods of Calculating Depreciation

Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life. It represents how much of an asset's value has been used up. Businesses depreciate long-term assets for both tax and accounting purposes. There are several widely accepted methods for calculating depreciation amount. The question asks about the validity of two specific methods: the Straight Line Method and the Written Down Value Method.

What is Depreciation?

Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. The objective is to charge a portion of the asset's cost against revenues generated by using the asset each period. This helps in matching costs with revenues and shows the gradual decline in the asset's value due to usage, wear and tear, obsolescence, or passage of time.

Analysis of Depreciation Methods

Let's examine the methods mentioned in the question:

I. Straight Line Method

• This is the simplest and most widely used method of calculating depreciation.
• Under this method, a fixed amount of depreciation is charged every year throughout the useful life of the asset.
• The assumption is that the asset loses value uniformly over its life.
• The formula for calculating annual depreciation using the Straight Line Method is:

\(\text{Annual Depreciation} = \frac{\text{Cost of Asset} - \text{Estimated Salvage Value}}{\text{Estimated Useful Life of Asset}}\)

• This method results in a constant depreciation expense each period, leading to a constant book value decrease.

II. Written Down Value Method (Reducing Balance Method)

• Under this method, depreciation is calculated at a fixed percentage on the diminishing book value (or written down value) of the asset each year.
• The book value is the original cost minus accumulated depreciation.
• Since the depreciation is calculated on a reducing balance, the depreciation amount decreases each year.
• This method assumes that an asset is more efficient in its early years, and thus, its depreciation is higher initially, decreasing as the asset ages.
• There isn't a simple universal formula like the straight line method, as the percentage rate is often determined based on the asset's nature or prescribed by regulations. However, the concept is:

\(\text{Depreciation for the year} = \text{Opening Written Down Value} \times \text{Depreciation Rate}\)

• The opening written down value for the first year is the original cost of the asset. For subsequent years, it is the book value at the beginning of the year.

Conclusion on Methods of Calculation

Both the Straight Line Method and the Written Down Value Method are recognized and valid methods for calculating depreciation expense in accounting. They are commonly used by businesses to allocate the cost of assets over their useful lives.

Therefore, the methods listed, I. Straight line method and II. Written down value method, are indeed methods of calculating the depreciation amount.

Revision Table: Comparing Depreciation Methods

Additional Information: Depreciation Concepts and Other Methods

Understanding depreciation involves more than just the calculation methods. Here are some related points:

• Causes of Depreciation: The main reasons why assets depreciate include:
  • Physical Wear and Tear: Due to usage.
  • Obsolescence: Becoming outdated due to technological changes or new inventions.
  • Passage of Time: Expiry of legal life or simply aging.
  • Depletion: For natural resources like mines or quarries.
• Factors Affecting Depreciation Amount:
  • Cost of Asset: Includes purchase price, installation costs, etc.
  • Estimated Useful Life: The period over which the asset is expected to be used.
  • Estimated Salvage Value (or Residual Value): The estimated realizable value of the asset at the end of its useful life.
• Other Depreciation Methods: While Straight Line and Written Down Value are common, other methods exist, including:
  • Sum of Years' Digits Method
  • Double Declining Balance Method (an accelerated method)
  • Units of Production Method (based on usage rather than time)

Selecting the appropriate depreciation method depends on factors like the nature of the asset, its expected usage pattern, and regulatory requirements.